Capital structures: Where do we go from here?

2014-08-06

From wire report

The Latvian government needs to think about how regulatory policies can be used to advantage in the global competition to attract foreign investment

The optimality of capital structures, namely the way companies are financed, or more precisely the debt-to-equity ratio, might not seem the most passionate topic to read about. However, how companies are financed could have a significant impact on their valuations.Capital structure influences a firm’s cost of capital. For a given riskiness of a project and forecast cash flows from the business plan, the greater the return expected by an investor, the less will be the value of the firm.This shows that the capital structure chosen influences the value of the firm.

Choosing the locationNow assume that for a given company with a given riskiness and projected cash flow, the capital structure and, thus, its cost of capital differs across countries, then the company should, at least partly, develop its activities where the value of the company has a higher value. As an example, take a company that has activities in Europe and can register in Poland or the Baltics. If the valuation is higher in the Baltics because of conditions that lead to a more favorable capital structure, it should register in the Baltics.

For governments, however, it is possible to influence the optimal capital structures by better regulation and infrastructure. Influencing capital structures thus becomes a policy tool.The typical economics and finance student has learned that capital structures do not influence the value of the firm. That was a big insight by Modigliani and Miller, who earned the Nobel Prize for their work in corporate finance. However, the so-called Modigliani-Miller Theorem holds only in a world without friction, one where people are totally rational, the rule of law is effective and where there are no taxes or asymmetry of information.

In the “real world,” all those frictions exist, the first among them taxes. The optimal capital structures in different countries will thus be dependent on the respective differences in taxes and laws.Some more advanced theories have been developed by the corporate finance theorists. For instance, the trade-off theory suggests that the managers of a corporation have to trade off the tax gains of debt with the increased riskiness of going bankrupt. It is worthwhile highlighting, for those not familiar with the subject, that debt payments are not taxed at the company level, whereas income is taxed. This leads to an implicit “tax shield” of debt.It turns out that, although, those theories attempt to predict how an optimal capital structure can be reached, in the real world the observed capital structures are below their predicted optimal levels in most countries.The issue of the optimal capital structure and the concomitant valuation is thus an interesting topic. In our case, Latvia is of special interest.

Let’s focus on what Latvian manufacturing data reveal. The analysis of data from 2012 reveals that the largest Latvian manufacturing companies exhibit lower leverage ratios than manufacturers in other developed countries, the U.S. for instance. The observed, which is not necessarily the optimal mean leverage ratio, for the sample of Latvian manufacturing firms was 20.5 percent, but the leverage for the median global firm was 13.4 percent.Overall, the leverage ratios vary in a range from 0 to 50.7 percent. Note that one third of firms in the sample are not levered at all, and that another third are over-levered. While the most recent approaches identify the optimal capital structure through the implicit spreads on leverage, most of the earlier research approaches had difficulties pinning down the optimal capital structure.

Therefore, many prior research papers discussed the determinants of the leverage in a particular country based on various factors, such as the size of the firm, the profitability, the fixed assets ratio and others. By using statistical approaches, researchers were able to determine the relevant capital structure theory in line with the respective financing patterns.

According to the research, profitability and state ownership were found to be negatively correlated to leverage, while the reputation and fixed assets ratio, as well as the concentration of shareholders, were positively correlated with debt levels. Similar results were found in Lithuania. Companies seem to prefer internal funding through retained earnings, which seems to indicate a high degree of asymmetry of information.It has to be highlighted that in most countries leverage is below the optimal level predicted by the standard trade-off theories. Typical corporate finance specialists would explain it through more advanced corporate governance-related issues, namely the impact of asymmetry of information between managers and investors, which leads investors to use debt contracts to force the management to pay out cash.

Protecting the investorsThose factors are relevant, but are apparently limited in their scope. The law and finance literature, however, provides interesting analytical tools. This literature focuses on legal rules and on how they protect investors’ rights. Depending on how favorable these rules are, the shareholders and creditors are willing to finance companies in varying degrees. This willingness is reflected in changes to capital structures of companies under respective jurisdictions.This literature focuses on the major legal systems and distinguishes civil law and common law systems. They have different traditions in the law-making process. Civil law implies a strict top-down rule book imprinted in codes of law. This is the system in, for example, Latvia, France and Germany. Common law is based on court decisions. In this sense it is bottom-up, with the most evident jurisdictions the United States, the United Kingdom and Australia.

Research indicates that common law countries have better investor protection than do civil law countries. The differences in legal traditions were mentioned as the reason for better development of capital markets in common law countries. Some have argued, however, that political and cultural factors have to be taken into consideration for the development of investor rights protection.In that respect, Latvia’s level of investor rights protection does not look flattering when compared to the average level of protection around the world. The World Bank’s annual index on Protecting Investors puts Latvia 67th among 188 countries.

This index is based on three categories of indicators: the extent of disclosure, the extent of director liability and the ease of shareholder lawsuits. Despite the recent investor-friendly changes in laws, Latvia’s position has not improved since last year.

The assessment of investor rights protection according to World Bank guidelines comprises several aspects relating to shareholders and creditors. In Latvia, the requirements are only partly fulfilled. On the one hand, regarding shareholder rights, Latvian laws provide for the one-share-one-vote rule, voting before meeting in writing, voting during the meeting via an authorised representative, voting by email or mail and if the statutes of the corporation allows, a minimum level of ownership of share capital in order to call extraordinary meeting, set at a low 5percent level for all initiators together.Concerning the decision-making procedure for shareholders wanting to participate in meetings, the law allows for participation by those showing ownership of shares with a record date of 8 working days before the meeting. On the other hand, this requirement of physical presence in voting is conditional under the statutes of the corporation, which in reality limits the initiative. Moreover, the law is silent on cumulative voting procedures.

With regards to creditor protections, the assessment is more disappointing. According to the World Bank guidelines, the requirements are mainly related to the process of reorganization. On a positive note, according to Latvian laws, creditors must be informed about a decision of reorganization within 15 days after that decision has been made. Moreover, creditors are informed about the place and time of a deadline for submitting claims on collateral.

On the other hand, many grey areas remain on whether the creditors’ consent is required for filing for reorganization, including: Whether the creditor can repossess the collateral before closing the reorganization, what is the position for the secured creditor in the line of creditors, what are the powers of the management during the process of reorganization.In summary, there is leeway in improving investor protection in Latvia. The latest research and literature in law and finance can help analyze potential policy decisions. In this respect, the government should keep in mind how it designs the regulatory regime and its impact on company valuations. This has an impact in terms of attractiveness for Latvian as a destination for foreign investment.

Dr. Michel Verlaine is a managing director and co-founder of SLF Specialists in law and finance (www.slf.eu.com). Alina Rektena is a consultant with SLF Specialists in law and finance.

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